This blog post is referring to a very old study of Closed End Funds (CEFs) that I read this year. CEFs are the equivalent of what Australian investors usually refer to as ASX Listed Investment Companies (LICs). The study discusses in detail the typical life cycle of CEFs. It talks about why they often swing from premium to discount, and then back to NAV in a fickle manner.
I previously linked to this study on this blog, but here it is again for those that are interested. (warning – long read!). You can come back to it later if you like.
I found it interesting that they conclude that the sometimes wild swings in discounts / premiums are largely sentiment related rather than any rational fundamental pattern. Given that this study was back in 1991 one might think that markets would gradually get a little bit more efficient in this area. From what I have observed by looking at ASX LICs very closely for a decade now, is that is not the case. Things still seem very sentiment driven and inefficient.
Let me take some interesting snippets out of this old detailed study and expand on this point. The study outlines four key stages in the typical life cycle of a CEF.
1) IPO and a premium shortly after due to listing costs deflating the NTA.
2) After four months of trading it is quite normal to see a discount of about 10%.
3) Wild fluctuations in the discount through the life of the CEF. Fluctuations in the discount appear to be mean reverting. Significant positive abnormal returns from assuming long positions on funds with large discounts.
4) When CEFs are terminated through liquidation or other events such as converting to open ended structure, mergers etc, discounts substantially narrow on announcement. A small discount remains until the event is realised.
How Is This Relevant for ASX LICs in Recent Years?
Nearly three decades later from this study I still see quite similar trends here on the ASX. Perhaps there are some minor differences, but the overall themes remain the same in my opinion. I shall elaborate a little in terms of the four stages mentioned above and tie it back to recent times on the ASX.
1) IPO and early stage premium – the ASX LIC conflict of interest stage?
Thankfully the listing costs are not as bad anymore as referred to in this old study. In fact, one good thing about LIC IPOs over the last year or two is that they have increasingly absorbed the listing costs, rather than the investor getting hit. For example, even in 2014 – 2016, we saw a heap of new LICs hit the market and quite often the investor would start with 97 cents worth of assets but had to pay $1 in the float. Much of the costs would be commissions.
I have been reading with interest Christopher Joye writing some articles in this area.
Usually we see the shares manage to hold their float price for a few months. Investors have gone to the effort of finding the application area details of the prospectus (I suspect the only part that many LIC investors read), so they will tend to hang on for a while.
That can often lead to holding a small premium to NTA for a little while. The promoters of the LIC have become skilful at instilling a bit of FOMO into the heads of investors also. Stockbrokers often were receiving a commission to place the LIC IPO with their clients. To help create demand they assist the fund manager in creating a good story to the media. Often a lot of hype is generated over their great long term (think 3 years or so in some cases!) performance records. Fees, MERs, IMAs are usually kept quiet on the other hand. The slick sales effort can often see the premium maintained for a while.
2) Discount to NTA soon appears after the shiny new car feel wears off
The old CEF study mentions a period of about four months in when already it is common to see a discount to NTA develop of circa 10%. From my observations in recent years on the ASX the discount widening probably sets in a bit later than that. I tend to liken it to how some people like to buy the brand new car out of the show room and it very quickly loses value after that.
Perhaps with LICs the discount can escalate when the brokers see another LIC IPO on the way. How about a trade idea they may say, sell Old LIC:ASX and buy new IPO ASX (where we get a commission)? There is no great need for the broker to say how great the fund manager is after their LIC hits the secondary market.
3) Volatile movements in the discount / premium to NTA, largely sentiment driven
If you think the LIC market has become more efficient over a long time then consider some of the premiums to NTA that have occurred on occasions.
I am talking about paying a premium of 30%, or even 40% in some cases. I am not talking about some strange inefficiency decades ago. Such large premiums have been seen in recent years.
Some staggering examples that spring to mind quickly for me are Wilson LICs, e.g. (ASX:WAM), (ASX:WAX), (ASX:WAA). Quite a few other examples of massive premiums at times. You could take a look back at the likes of (ASX:ALF), (ASX:PMC), (ASX:MIR), (ASX:DJW), (ASX:FOR).
Of course its not all bad, some staggering discounts have been seen also. I mentioned above WAX, from memory it was formerly managed by Wilson with a different strategy under the ticker WIL. I think it spent plenty of time at a discount in the 25-30% range. The now highly regarded Magellan LIC in (ASX:MFF) traded with a discount to NTA of circa 25% for quite some time after the GFC ended.
Being an investor for a living, I can only hope such wild swings in sentiment can continue in the future.
Surely some of the extremes like this is a bit of mean reversion going on? As the old CEF study suggests it is probably better to have a bias to assume long positions at very large discounts to NTA. Given I have a focus towards deep value investing, this study paper is consistent with the way I approach the CEF sector.
4) Activism and winding up LICs
A big part of the opportunity with LICs is when we can not only buy a good fund manager at a large discount, but also when a wind up is possible. Ideally you would want the scenario that happened with MFF. That is, you can buy them at a 25% discount to NTA around 2009/10 and live happily ever after as they invest your money well.
The odds can even be more stacked in your favour if you still win from another scenario. Perhaps in the next couple of years the fund manager continues to struggle a little. If the IMA structure / other shareholder ownership potentially lean towards a liquidation event, you can have a large buffer to cushion any downside (e.g. Discount contraction of 25% over a couple of years).
Unfortunately on the ASX now we still have many newer LICs that began in the last few years. This means they are often less than half way through a 10 year IMA term.
Getting back to the old CEF study I have been referring to, we can point to some significant liquidation events occurring around the GFC in Australia. The approximate numbers I remember is that the LIC universe consisted of about 60 leading up to the GFC. Nearly a third of them somehow disappeared over the following few years. Yet as I write today we have easily more than 100! I suspect when a lot of these IMA terms expire, we may well lose about a quarter of the LICs that exist today.